Finance Project (Need answers changed)

John DeFeo

Dr. Kang

Corporate Finance 201

May 6 2020

Group Project Responses

Scenario 1 Questions:

1a. Would you accept the project based on NPV and IRR?

Yes, we accept the project because the net present value is positive and the IRR is above the cost of capital. The cost of capital is 13%, compared to the original rate of 10%.

1b. Would you accept the project based on Payback rule if the project cut-off is 3 years?

No, we do not accept the project because the value of the Payback rule is equal to 3.8 years while the maximum cut off was supposed to be 3 years.

2. How would you explain to your CEO what NPV means?

Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a certain time period. It is a value and method used to identify profitability.

3. What are the advantages and disadvantages of using the Payback method only?

The most important disadvantage of using only the Payback method is the fact that it ignores the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. The advantages of using this method include its simplicity and the fact that it offers a quick evaluation which generates fast returns.

4. What are the advantages and disadvantages of using NPV versus IRR?

Some advantages of using NPV are that it maximizes company value. Similarly, NPV works in ascertaining the future cash flows of the projects in the present. Thus, the utilization of this model is reliable. Some disadvantages consist of it being prone to forecasting errors and estimates. The longer the project's tenure, the greater the risk of errors. The estimate may be more accurate for a short project than the estimates for a longer tenured one. The forecasting error may therefore render the NPV method efficient.

On the contrary, most methods use the IRR as the basis for selecting a desired plan or project. The time value of money shows the value of money today as compared to the one in future. The IRR method takes into consideration the time value of money, making it highly reliable. Also, the hurdle rate is very important to the IRR, making it reliable enough to draw the results. However, the IRR method does not consider the required rate of return while viewing the results, allowing for a cover from any risk of wrong interpretation. Some disadvantages of the IRR are that it totally excludes the economies scale. It ranks the projects on the basis of the returns that they will produce. Also projects are mutually exclusive, meaning that while one project is accepted, the other cannot. Overall the NPV method is a more reliable and more efficient way of financing.

5. Explain the difference between independent projects and mutually exclusive projects. When you are confronted with Mutually Exclusive Projects and have conflicts with NPV and IRR results, which criterion would you use (NPV or IRR) and why?

The difference between independent projects and mutually exclusive projects is that the cash flows of a given project and investment are not altered by any acceptance in an independent project. However, within mutually exclusive projects, the cash flows of an investment or project might be adversely affected by the acceptance of either. When working with a mutually exclusive project, it is best to use NPV due to the ensured profitability and the return on an investment/project in comparison to the potential risk of acquiring the cash flows through the internal rate of return method.

Scenario 2 Questions:

Impact of 2017 Tax Cut Act on Net Income, Cash Flows, and Capital Budgeting (Investment) Decisions:

1a. Estimate NPV, IRR, and Payback Period of the project if equipment is fully depreciated in the first year and tax rate equals to 21%.

The NPV is $22,189.21. The IRR is 14%. The Payback Period is 3.70 years.

1b. Would you accept the project based on NPV and IRR?

Yes, we accept the project because the net present value is positive and the IRR is above the cost of capital. The cost of capital is 14%, compared to the original rate of 10%.

1c. Would you accept the project based on Payback rule if the project cut-off is 3 years?

No, we do not accept the project because the value of the Payback rule is equal to 3.7 years while the maximum cut off was supposed to be 3 years.

2. As a CFO of the firm, which of the Scenarios (1) or (2) would you choose? Why?

As a CFO we would choose scenario 2 because both the net present value and IRR are higher than those values in scenario 1. Therefore, the project in scenario 2 is more appealing.